Rough Diamonds Inequality

‘ROUGH DIAMONDS’: HOW GREATER EQUALITY OF OPPORTUNITY HAS LED TO GREATER INEQUALITY OF OUTCOMES

Rising inequality in the US since the 1970s can be explained by the rising equality of opportunity in education, according to analysis by Theodore Koutmeridis, presented at the Royal Economic Society’s 2013 annual conference. His study seeks to explain how countries such as the US have experienced a rise in opportunity over the last few decades as well as a rise in inequality.

The author presents a theory suggesting that when credit becomes more easily available – as has been the case over the last few decades – people from low-income families find it easier to borrow and go to university. Over time, this means that the group of uneducated young workers will be of a lower average quality because most of the 'rough diamonds' will have been plucked out of this group. In response, firms offer lower wages to the remaining workers of this unskilled and inexperienced group, which ultimately leads to a rise in wage inequality.

The research uses the example of the US, where there has been a rise in the ‘education premium’ paid to workers despite the increased supply of educated workers. Between the 1970s and the 2000s, the research shows that the inflation-adjusted wages of unskilled and inexperienced workers have fallen by 20%.

Moreover, because more and more people have a good education, employers assume that more of the high-ability workers are those with an education. Those high-ability workers without an education need to prove themselves. The research claims that this explains why there has been a rise in wages for low-skilled workers with a lot of experience, as this suggests they too are highly able.

The author argues that this theory explains why inequality has risen more in the US, where people must pay for their education and there has been a rise in availability of loans, than in continental Europe, where education has always been relatively cheap or even free. The author concludes that there are key lessons for policy:

‘Current policies are misguided because they ignore the inequality-enhancing side effects of fair opportunities.

If apart from offering just equal opportunities, policy-makers also target reducing inequality in outcomes, they should adopt policies to mitigate the unintended consequences that lead to a more divided society.’

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Since the 1970s, countries like the US have experienced the puzzling co-existence of more equal opportunity with higher wage inequality. Even though the sharp increase in wage inequality is well-known, we still lack a rigorous understanding of its perplexing patterns. In particular, for workers with low education, job experience accounts for a rising amount of pay disparities. Similarly, for inexperienced workers, education plays an increasingly important role in determining wage discrepancies.

Existing studies cannot explain these trends, as their emphatic focus on education and technology has diverted attention from other vital developments, such as the impact of working experience, the role of asymmetric information and the influence of financial frictions.

This research provides a new way to explain the puzzle. It shows that when credit becomes more widely accessible, talented individuals from low-income families find it easier to borrow and thus can go to university. This has an important effect on society. In fact, it implies that the eventual group of uneducated young workers becomes of lower average quality because most of the 'rough diamonds' have now been plucked out of this group. In response, firms offer lower wages to the remaining workers of this unskilled and inexperienced group, which ultimately boosts wage inequality.

This explanation is consistent with the pattern of US wage inequality from the 1970s till the 2000s. Over this period, the rise of the education and the experience premium coincides with a decline of more than 20% in unskilled/inexperienced wages, while at the same time real wages for skilled or experienced workers do not change much. This theory accounts for:

the increase in the education premium despite the growing supply of skilled workers;

the neglected aspect of rising inequality related to the increase in the experience premium;

the sharp growth of the education premium for inexperienced workers and its moderate expansion for the experienced ones;

and the puzzling co-existence of an increasing experience premium for low-educated workers with its stable pattern among the highly educated ones.

The underlying mechanism is based on three realistic components of labour markets: first, education signals worker ability to uninformed firms; second, firms privately learn the type of their own employees as working experience increases; and third, financial markets are imperfect leading to credit constraints.

The combination of signalling and credit constraints does not allow firms to distinguish the less talented from the talented but poor workers, as neither of them can acquire costly education. These two elements explain the rise in the education premium.

But when firms privately learn the type of their own workers, they can correct the initial mistakes they have made by adjusting wages according to worker productivity. The inclusion of private employer learning not only applies to reality, but it also explains the rise in the experience premium, as well as the complex patterns of wage inequality within different education-experience groups.

This research reveals the potential conflict between equality of opportunity and substantial wage inequality in a realistic setting. The key findings are consistent with the experience of Anglo-Saxon countries and especially with the US, where society has become more meritocratic but economic inequality has increased sharply since the 1970s.

In continental Europe, wage inequality has not changed much, as the college tuition is low or zero, so easier credit does not affect education choices. It also suggests that current policies are misguided because they ignore the inequality-enhancing side effects of fair opportunities.

The proposed theory is coherent with a combination of facts that cannot be explained by others, which reinforces the validity of the following policy message: if apart from offering just chances, policy-makers also target on reducing inequality in outcomes, they should adopt complementary policies at the top of equalising educational opportunity to cushion its unintended consequences that lead to a more divided society.

ENDS

Notes for editors:

‘Information, Finance and Wage Inequality’ by Theodore Koutmeridis

Theodore Koutmeridis is a Junior Fellow of the ‘Royal Economic Society’, a PhD candidate in Economics and a Teaching Assistant at the University of Warwick.

Career/Education

The Royal Economic Society is one of the oldest and most prestigious economic associations in the world. It is a learned society, founded in 1890 to promote the study of economic science in academic life, government service, business, industry and public affairs. The Society has approximately 3,000 members, of whom 60% live outside the United Kingdom.